Wednesday, 12 November 2008

Taxing times

With competing arguments and proposals for a fiscal stimulus in the economy dominate Westminster yesterday, the politics of tax, spending and borrowing are the focus of the political and economic commentators.

Cameron made the new dividing line in British politics whether the Government should finance any tax cuts from even higher borrowing. He says No, Brown says Yes. But the momentum in the great tax debate is with Brown for now, not least because he can take action that will affect people's pockets rather than just call for something.

“Should the money go on lower taxes or higher spending? The immediate political pressure is to go down the tax-cutting road … Even so, the prime minister would be wise to siphon some of the available funds through government programmes. For one thing, the poorest third in society - many pensioners, many disabled people and many one-parent families - pay no income tax at all. For another, Labour is never likely to win a tax-cutting auction, when its most important achievement in office has been to improve public services by spending more. Besides, an anxious public might bank up its tax cuts as savings - dampening the economic effect - whereas public investment will more directly stoke demand”.

“No doubt anxious to seem "responsible" in the way a party that sees itself as a government-in-waiting should, it succeeded only in looking timid and unambitious. The plan to give a tax break to companies taking on unemployed people is excessively complex, does not put money into people's pockets - surely the priority in a downturn - and is far too modest in its scope. Costing £2.6 billion, just half of one per cent of the total tax take, it would barely be noticed”.

A strong argument ... is weakened by uncertainty over what kind of stimulus would actually work. There are three broad options. The first would be to bring forward spending on key public projects - but planning law and other glitches could mean such spending comes too late. A second option would be income tax cuts. But across-the-board cuts would be likely to raise saving, not spending. Channelling money to the poorest would probably result in spending, and would help those most in need. This is particularly attractive to some Labour MPs, who sense a last opportunity to redistribute wealth. But it is also risky: co-ordinated international action would be needed to prevent the extra cash disappearing into imports. A third and more effective option would be targeted and temporary tax cuts. VAT, for example, could be cut by up to 2.5 per cent under EU law, with a promise that it would revert to its current level in a year's time. This would have the benefit of being easy and quick to achieve, and would create an immediate incentive to spend.

Most people will save the windfall rather than spend it, knowing payback time is just around the corner.Were the government to be proposing targeted tax cuts for those on low incomes or for small businesses, paid for by a new top rate for the well-off, the scrapping of indentity cards or Trident, it would be a different matter. That would be affordable, and could do some good. Brown, though, has fallen into the old trap of thinking bad economics makes good politics.

The world has a lot of experience of the effect of fiscal and monetary boosts, and that experience is not encouraging. Japan gave a huge boost to its economy in the 1990s, driving interest rates down to zero and running a fiscal deficit that ran at 8 per cent of GDP. It didn't work. This year the US has given a big boost to the economy and demand did perk up in the summer. But now the country is heading into recession, along with everyone else.